FX risk, also known as foreign exchange risk, foreign currency risk, or exchange rate risk is the potential for financial loss due to fluctuations in exchange rates between two different currencies. This risk arises when a business or investor is involved in international transactions, investments, or operations that require converting one currency into another.
Key points about FX risk:
It can impact businesses, investors, and individuals engaged in cross-border transactions or holding assets denominated in foreign currencies. FX risk occurs because exchange rates can change unpredictably between the time a contract is signed and when payment or settlement occurs, potentially causing losses.
The main types of foreign exchange risk are:
- Transaction Risk: This is the risk that arises from the time lag between entering into a contract and settling it, during which exchange rates may change. It affects companies involved in international trade, as the value of payables or receivables in foreign currency can fluctuate, impacting profitability and cash flow.
- Translation Risk (also called accounting risk): This risk occurs when a company needs to consolidate financial statements from foreign subsidiaries into its home currency. Changes in exchange rates can alter the reported value of assets, liabilities, revenues, and expenses, affecting financial ratios and how stakeholders perceive the company’s financial health.
- Economic Risk (also known as operating or forecast risk): This is the long-term risk that exchange rate movements will affect a company’s future cash flows, competitive position, and overall market value. It is broader than transaction or translation risk and considers the impact of currency fluctuations on future business operations and strategy.
Other risk are:
- Jurisdiction risk: The risk that changes in laws, regulations, or political stability in a foreign country could affect currency convertibility or the ability to repatriate funds. This is especially relevant in countries with unstable legal or political environments.
- Liquidity risk: Liquidity risk in FX (foreign exchange) is the risk that an entity will be unable to buy or sell a currency in the desired amount, at the desired time, or at a reasonable price, without causing a significant impact on the exchange rate or incurring substantial losses. This can occur due to insufficient market depth, disruptions, or limited convertibility of certain currencies. Liquidity risk in FX is most prevalent in emerging markets (EM) and frontier markets. These markets are characterized by: lower trading volumes and market depth, capital controls and regulatory barriers, higher sensitivity to global risk sentiment, reliance on foreign currency financing. In contrast, major developed market currencies (like USD, EUR, JPY, GBP) typically have deep and liquid FX markets, making liquidity risk much less significant except during extreme global financial stress.
